Chapter 2 Flashcards
Treasury Bills (UK T Bills)
- What are main loan terms
- Who manages governments daily cash flow needs
- Minimum nominal purchase
- Describe risk
- how issued and when and by who
- 1 month, 3 months @ 91 days and 6 month loans . 3 months mostly
Like a very short term Gilt - DMO Debt Management Office manage daily cashflow for government
- Min nominal purchase £500k
- virtually risk free and highly liquid -used as risk free rate of return
Issued at a discount and redeemed at face value (par) No coupon
- Usually issued on Fridays. Parties submit price and if successful they pay price they submitted(called competitive auction)
Calculate simple method for Treasury Bill
91 day T-Bill
Par £100k
Investor pa £98,500 held to redemption
Receives £100k and £1,500 k growth over 91 days ( like £1,500 every 91 days on £98,500)
365/91 x £1.5k/98.5k = 6.11%
Commercial Paper
- who issues
- Maturities
- Risk
- Companies
- Maturities between 30 and 90 days
Another name for debts securities
- Gives what rights to owner
- redemption periods
- Bonds/financial instruments
- Right to repayment of capital and interest on loans made to government and companies
30 years - Bonds cheapest method of borrowing money
Running yield of a Gilt
Formula ?
Coupon divided by price multiplied by 100 to get percentage
So if a bond is priced at a clean price of £120 and it’s paying a coupon of 5% then you divide 5% by £120 to get 0.04166 – multiply this by 100 to get 4.17%.
The investor actually receives £5 gross each year, but because the price paid was more than £100 (it was trading above par), then the equivalent return is less than 5%.
To take this one step further, we need to remember that if this bond is held until redemption, the investor will only get back £100 so will make a loss.
.Redemption yield
So let’s now calculate the redemption yield assuming the investor does hold it until maturity.
Let’s assume the bond has 6 years left to run.
It was bought for £120, so at maturity there will be a capital loss of £20. With 6 years left to run, we can say that this is a £3.33 capital loss for each year left. As a percentage of the price that was paid this is – 2.78%. We then take this from the running yield we worked out earlier of 4.17% to give an approximate yield to redemption of 1.39%.
The formula is:
Interest yield + / – (gain (or loss) to maturity / number of years to maturity) divided by clean price, then multiply by 100
Gross Redemption Yield or Yield to Redemption
Formula
Step by step?
Running yield +/- Annualised loss or gain as percentage of purchase price
Yield +/- Gain/Loss to maturity /years to maturity
_________________________________________x100
Clean Price
- Work out running/flat yield
- Work out gain/loss eg £98 purchase would be £2 gain
- divide by years to redemption
- Gain/loss as percentage of purchase price
What are main risks associated with holding either Government of Corporate Bonds
- Credit risk: interest payments and repayment of bond may not be made
- Market risk : inverse relationship between prices & interest rate
- Inflation risk - real value of bond coupon and redemption repayment
- Liquidity risk
- Exchange rate risk- bond denominated in different currencies
Three key risks that make up bond price
- Credit risk. Credit rating agencies make assessment (and through term)
Investment grade or non investment grade (junk bonds). EG use S&P ratings. Less then BBB is junk - Market risk. income/coupon remains same through term. Yields reflect changing interest rates by a rise or fall in price in capital value.
Volatility - Various bonds have different sensitivity when interest rates or yield change (made up of different coupons and terms)
Measure is called Duration or Modified Duration
What is inverse relationship between Bond pieces and yield/interest rate
What is Gross redemption yield (GRY)
What happens to GRY if bond is trading below par
- Bond Price up / Yield down
- Yield up / Bond price down
GRY represents Total return (assuming bond held to redemption) Takes into account both coupons received and any capital gain/loss at redemption.
When bond is trading below par, GRY will be greater than flat yield. Above par, GRY less than flat yield
Net Redemption Yield
What is difference between GRY & NRY
How do you calculate
Difference between GRY & NRY is tax deduction for BRT, HRT etc to Flat/ running yield
Example
HRT investor purchase 10 year 6.5% coupon bond for £93. Calculate NRY
A) Calculate flat yield: 6.5/93 = 6.99%
B) Deduct 40% (HRT) 6.99 x 60/100 = 4.19%
C) Calculate profit/loss - £7 gain / 10 years /93x100% = 0.75% (capital gain/loss per annual as % of price paid)
D) Total = 4.19% + 0.75% = 4.94%
Fixed interest Risk
- Interest rate & inflation
- Reinvestment risk
- default risk
- Specific risk
- Volatility
- Interest rates rise, fixed int bonds/Gilts price falls.(see saw correlation).
Longer dated gilts will fall/rise by a greater proprtion
Reduce: Buy shorter dated stocks to reduce duration risk - But yield usually higher for longer dated (more risk ,more yield) - Reinvestment risk. As one gilt matures, you cant reinvest into another gilt give the same rate of interest due to changes in market and interest rates. Not good if rely on certain amount of income
Reduce: But gilts of different durations to average return and keep gilt return more stable.Any changes will then be transitioned more smoothly rather than all at once. May need to take on more risk such as corporate debt and equities to get same income - Default risk. Government defaults on coupon or capital at maturity. Very low risk of happening. Uk was downgraded to AA rating
Reduce: could diversify into other countries sovereign bonds to reduce risk. Then exchange risk which is arguably more than default risk
Downgrade Risk
Systematic Risk
Liquidity risk
- Downgrade risk. Risk UK credit rating is reduced. This could increase yields on existing bonds as investors demand a higher return for higher -perceived default risk
Reduce: Hold shorter dated gilts and I’d sift across other countries gilts may help reduce risk via diversification - Systematic risk: risk of global crisis, causing most/all asset classes to fall together.Correlatyion converges.
Reduce: CAPM suggests we cant diversify this risk away. Gold eg could protect downside - Liquidity risk. May not be able to buy or sell an investment at sufficient quantities
Reduce: Gilts are liquid so limited liquidity risk. Longer dated gilts less so than shorter term. Diversified portfolio will help minimise liquidity risk. Additionally, exposure could be gained by an open ended fund where investor can sell unit/shares back to fund manager
Political Risk
Inflation risk
- Political risk- change in government policy could reduce real rate of return on gilts.EG removal of personal allowance or increase in income tax
Reduce: Depends. Holding gilts in different tax wrappers eg ISA and pensions will help against tax example
-Inflation risk - interest to redemption is fixed. Eroded by inflation over holding period.
Reduce: buy index linked gilts to remove inflation risk: but real yield are low or negative
- Explain what is meant by duration
- Duration : Amount of time in years required to regain cost of a fixed interest security, taking into account yield/coupon and return of capital on redemption.
For every 1% of movement in interest rates (up or down) the bond value will move by the value of it’s modified duration in the opposite direction.
Higher the bond duration, the more sensitive it is to interest rate changes - Duration is likely to underestimate rises in value and overestimate falls in value (convexity)
